How about that Amazon earning gap! The more I analyze it, the more lessons I can find worth mentioning.

As a precursor to today’s comments, I highly recommend reading “11 Things you Need To Know Before Trading Earnings.” It provides the backdrop needed to understand my analysis below fully.

Amazon was this earnings season poster child for outliers. Ahead of last Thursday’s report, the market was pricing in a $62 overnight gap. That was the Market Maker Move (MMM), in other words. From a probability perspective, there was about a 2/3rds chance (61.8%, to be exact) that AMZN would move less than $62 and a 1/3rds chance (38.2%) that it would move more than $62.

Traders looking to stack the odds in their favor usually deploy short strangles or iron condors ahead of the event. Given AMZN’s lofty price tag, all but the clinically insane should have used the limited risk avenue of condors.

Most of the time (read: 2/3rds or more), you should wake up the next morning near breakeven or profitable.

But the other 1/3rd or so? That’s where the Amazon-like reactions come in.

AMZN didn’t just move more than expected. It blew the roof off the house and ran 3x the forecast. Friday’s intraday peak was $185 higher than Thursday’s close.

But it doesn’t necessarily mean that the options market got it wrong. AMZN was just one of the roughly 1/3rd that exceed the expected move. Unfortunately, the losses on the 1/3rd can quickly wipe out the gains from the 2/3rds. What if you sold condors into earnings for NFLX, AAPL, MSFT, and AMZN? You probably won on the first three, but may have given back that much (or more!) on the AMZN loss.

Such is the challenge with trying to game earnings. Because of the lopsided risk-reward (high risk, low reward) nature of short volatility strategies, all it takes is one or two Amazons to destroy your profits.

So does that mean we should swing bi-directional, long volatility trades into earnings?

Not necessarily. Had you used debicons or inverted flies into earnings reports for the previous four stocks mentioned (NFLX, AAPL, MSFT, AMZN), then you would have lost on the first three while winning on the fourth.

And my guess is you would have come out around breakeven.

Neither approach is a slam dunk. That’s not to say that trading earnings can’t or won’t produce a profit. I’m sure there are some people out there that love earnings season and with great management are able to score profits. I’m just not one of them.

Gap Management

Here’s another takeaway from Amazon’s reaction -how to deal with gaps using an intraday chart.

Let’s say you got squeezed on a condor into the gap. Did it pay to take the loss right when the market opened? Nope! That’s because AMZN actually traded lower for the first 15 minutes, dropping as much as $50 from the open. In fact, we have yet to take out the high of the first five-minute bar, even though three trading sessions have passed.

Here’s my suggested technique to try minimizing losses when a stock gaps against you.

First, let the stock trade for 5 to 15 minutes. The high for an up gap is often made right at the open. Additionally, this lets bid-ask spreads tighten up so you don’t get shafted with a market order at the open.

Second, mark the high of that period (or low if it’s a gap down).

Third, use that as your new stop point.

Fourth, if you see a modest gap fill, consider taking your trade off with less of a loss than at the open. Otherwise, jump ship if the new stop point is exceeded.

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